Naked short selling

Naked short selling, or naked shorting, is the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed. It has been illegal in the United States since 1934, with an exemption for bona-fide market makers intended to increase liquidity and stabilize markets. In 2004, the Securities and Exchange Commission (SEC) issued "Regulation SHO" seeking to curb abusive naked shorting.[1] However, SEC Chairman Chris Cox has recently stated publicly that Reg SHO has failed to achieve its intended effects, and has proposed tightening the rule.

Description

Normal shorting

For a more detailed treatment, see Short (finance).
Short selling is a form of speculation that allows a trader to sell securities that they do not own, effectively taking a "negative position". They do this when they expect the value of the securities to decrease in the market, allowing them to sell securities at today's price and then buy the securities back when they decrease in value. With a large enough move in the price, the trader can purchase the securities, "covering" their position, for less money than they received for selling them earlier. The opposite case can also occur; if the price increases they will be forced to cover at a higher cost, a money-losing trade.

In order to make the initial sale, the normal method is first to "borrow" securities from a current shareholder, typically a bank or prime broker, agreeing to return them at some future date. The trader then delivers these borrowed shares to the buyer, a third party. The Brokerage firm generally gets to use the proceeds of the short sale in their daily course of business and sometimes pays interest to the short seller on those proceeds. When the trader wants to "unwind" the position, he buys back the shares in the market and returns those to the lender. This short/borrow system ensures the trader has shares to deliver to his buyer. In some cases when the brokerage firm has to go outside of the firm to borrow shares from another broker, the initial broker pays some interest on the proceeds to the lending outside firm.

Naked shorting

Naked short selling is a case of short selling the shares without first arranging a borrow and, therefore, selling but not delivering shares. The Securities Exchange Act of 1934 stipulates a settlement period up to three business days before a stock needs to be delivered,[2] generally referred to as "T+3 delivery".

If the stock is illiquid or simply has a small number of outstanding shares, finding the borrow can be difficult to arrange. In these cases the trader normally arranges for the borrow before making the trade, to ensure delivery. In the case when a borrow cannot be arranged within that time period, shares will not be delivered to the buyer, then none will be received by the buyer, and the trade will be said to have "failed to deliver". While the stock price continues to fall, this failure to deliver the stock plays to the advantage of short seller, since the later he finally returns the stock the less it will cost him.

Naked shorting to drive down share prices violates US law. In recent years, a number of companies have been accused of using naked shorts in order to make profits at the expense of share prices. To do this, the trader simply enters a naked short with no intention of ever delivering the shares.[2] A large enough short sale could cause the price to fall, as is the case with any stock being sold, so as long as the trade is large enough to move the share price, the short is likely to be profitable. Normally this would be risky; if the price did move back up for other reasons, the trader would be driving the price up with every purchase, a condition known as a "short squeeze".[Citation Needed] But as long as the buyer turns around and shorts it back into the market, the price continues dropping, making the trades profitable even though no one actually holds any of the shares.[2]

"Legal" naked shorting would normally be invisible in a liquid market, as long as the short sell is eventually delivered to the buyer. However, if the covers are impossible to find, the trades fail. A sudden rise in number of fail reports will alert the SEC that something irregular is going on. In some recent cases, it was claimed that the daily activity was larger than all of the available shares, which would normally be unlikely.[2]

The US Legal Environment: Regulation, Litigation, Legislation

Regulation SHO

The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing failure to deliver securities.[3] It states that a broker or dealer may not accept a short sale order without having first borrowed or identified the stock being sold.[4] The rule has the following exemptions:

Broker or dealer accepting a short sale order from another registered broker or dealer

Bona-fide market making - Current legal naked shorting rules allow brokerages to make large profits doing "bona-fide market making" while stock markets are falling.[Citation Needed] The market maker exemption to the rules governing the practice is intended to allow market makers to naked short sell on a very temporary basis, in order to increase liquidity and stabilize markets.

Broker-dealer effecting a sale on behalf of a customer that is deemed to own the security pursuant to Rule 200[5] through no fault of the customer or the broker-dealer.[6]

Regulation SHO also created the "Threshold Security List," which reported any stock where more than 0.5% of a company's total outstanding shares failed delivery for five consecutive days. A number of companies have appeared on the list, including Krispy Kreme, Martha Stewart Omnimedia and Delta Airlines. The Motley Fool, an investment website, observes that "when a stock appears on this list, it is like a red flag waving, stating 'something is wrong here!'"[2] However, the SEC states that appearance on the threshold list "does not necessarily mean that there has been abusive naked short selling or any impermissible trading in the stock." [3]

Regulation SHO is intended to reduce the number of potential failures to deliver, and by limiting the time in which a broker can permit failures to deliver. The regulation requires broker-dealers to close-out open fail-to-deliver positions in threshold securities that have persisted for 13 consecutive settlement days.[7]

Enforcement actions under Reg SHO

In 2005, the SEC notified Refco of intent to file an enforcement action against the securities unit of Refco for securities trading violations concerning the shorting of Sedona stock. The SEC sought information related to two former Refco brokers who handled the account of a client, Amro International, which shorted Sedona's stock. [8] No charges had been filed by 2007.

In December 2006, the SEC sued Gryphon Partners, a hedge fund, for insider trading and naked short-selling involving PIPEs in the unregistered stock of 35 companies. PIPEs are "private investments in public equities," used by companies to raise cash. The naked shorting took place in Canada, where it was legal at the time. Gryphon denied the charges. [9]

In March 2007, Goldman Sachs was fined $2 million by the SEC for allowing customers to illegally sell shares short prior to secondary public offerings. Naked short-selling was allegedly utilized by the Goldman clients. The SEC charged Goldman with failing to ensure those clients had ownership of the shares. SEC Chairman Cox commented, "That is an important case and it reflects our interest in this area."[10]

In June 2007, executives of Universal Express, which had claimed naked shorting of its stock, were sanctioned by a federal court judge as “repeated and remorseless violators” of the securities laws. The SEC asserted that the company “appears to exist primarily as a vehicle for fraud.” [11] Referring to a court ruling barring CEO Richard Altomare from serving as an officer of a public company, New York Times columnist Floyd Norris said: "In Altomare's view, the issues that bothered the judge are irrelevant. 'Long and short of it,' he said in a statement, 'this is a naked short hallmark case in the making.' Or it is proof that it can take a long time for the SEC to stop a fraud."[12] Universal Express has claimed that 6,000 small companies have been put out of business by naked shorting, which the company says "the SEC has ignored and condoned."[13] A receiver was subsequently appointed to administer the company.

In July 2007, Piper Jaffray Cos. was fined $150,000 by the New York Stock Exchange (NYSE). Piper violated securities trading rules from January through May 2005, selling shares without borrowing them, and also failing to "cover short sales in a timely manner", according to the NYSE. [14] At the time of this fine, the NYSE had levied over $1.9 million in fines for naked short sales over seven regulatory actions.[15]

Also in July 2007, the American Stock Exchange fined two options market makers for violations of Regulation SHO. SBA Trading was sanctioned for $5 million, and ALA Trading was fined $3 million, which included disgorgement of profits. Both firms and their principals were suspended from association with the exchange for five years. The exchange said the firms used an exemption to Reg. SHO for options market makers to "impermissibly engage in naked short selling." [16][17][18]

In October 2007, the SEC settled charges against New York hedge fund adviser Sandell Asset Management Corp. and three executives of the firm for, among other things, shorting stock without locating shares to borrow. Fines totaling $8 million were imposed, and the firm neither admitted nor denied the charges.[19]

Further regulatory developments

In July 2006, the SEC proposed to amend Regulation SHO, to further reduce failures to deliver securities.[20] SEC Chairman Christopher Cox referred to "the serious problem of abusive naked short sales, which can be used as a tool to drive down a company's stock price." and that the SEC is "concerned about the persistent failures to deliver in the market for some securities that may be due to loopholes in Regulation SHO.[21]

In March 2007, the Securities and Exchange Board of India (SEBI), which disallowed short sales altogether in 2001 as a result of the Ketan Parekh affair, reintroduced short selling under regulations similar to those developed in the United States. In conjunction with this rule change, SEBI outlawed all naked short selling.[22][23]

In June 2007, the SEC voted to remove the grandfather provision that allowed fails to deliver that existed before Reg SHO to be exempt from Reg SHO. SEC Chairman Christopher Cox called naked short selling “a fraud that the commission is bound to prevent and to punish.” The SEC also said it was considering removing an exemption from the rule for options market makers.[24] Removal of the grandfather provision and naked shorting restrictions generally have been endorsed by the U.S. Chamber of Commerce.[25]

In March 2008, SEC Chairman Christopher Cox in March 2008 gave a speech entitled the "'Naked' Short Selling Anti-Fraud Rule," in which he announced new SEC efforts to combat naked short selling.[26] Under the proposal, the SEC would create an antifraud rule targeting those who knowingly deceive brokers about having located securities before engaging in short sales, and who fail to deliver the securities by the delivery date. Cox said the proposal would address concerns about short-selling abuses, particularly in the market for small-cap stocks. Even with the regulation in place, the SEC received hundreds of complaints in 2007 about alleged abuses involving short sales. SEC Commissioners Paul Atkins and Kathleen Casey expressed support for the crackdown.[27][28]

In 2007, WayPoint Biomedical sued DTCC for DTCC's refusal to comply with a subpoena request for documents Waypoint needs to track trades in the company's shares.[31]

Ten suits concerning naked short-selling filed against the DTCC were withdrawn or dismissed by May 2005.[32]

A suit by Electronic Trading Group, naming major Wall Street brokerages, was filed in April 2006 and dismissed in December 2007.[33].[34]

Two separate lawsuits, filed in 2006 and 2007[35] by NovaStar Financial, Inc. shareholders and Overstock.com, named as defendants ten Wall Street prime brokers. They claimed a scheme to manipulate the companies' stock by allowing naked short selling.[36] A motion to dismiss the Overstock suit was denied in July 2007.[37][38]

Legislators said they repealed the law with the understanding that the SEC would act on a federal level to alleviate naked shorting concerns. Utah state senate majority leader Curtis Bramble said at the time of repeal that he now believed that Overstock's motives were "highly suspect." Bramble said, "There are those who believe Overstock has been using the Legislature as a distraction against its own problems. It raises serious questions."[39]

Byrne described the repeal as a cave-in to industry pressure. "Tuesday night, Overstock Chief Executive Patrick Byrne compared Bramble's about-face on the issue to a betrayal, using a reference to the movie Jerry Maguire to make his point. 'It's like that scene where Jerry McGuire figures out that a prospect's father has sold him out by signing with a competitor. McGuire says, "Now. Wait. Tell me you didn't sign. Because I'm still sort of moved by your 'my word is stronger'n oak' thing," ' Bryne wrote in an e-mail." [2]

Controversy Over the Pervasiveness of Naked Shorting

There is much debate about the extent of this manipulation within US capital markets. For many years the general consensus was that this was a non-issue, and that only cranks mad that their stocks had gone down, or companies intent on creating distractions, ever brought this issue up. Since 2006, however, this conventional wisdom has been rapidly dissolving.

Naked short selling defenders

Until quite recently, regulators, hedge fund managers, and financial journalists downplayed the extent of naked shorting in the US.

On its Regulation SHO website ("Does Naked Shorting Drive Prices Down?" section), the SEC cites the prevalence of false claims of naked short selling in Pump and Dump fraud. The SEC downplays naked shorting as a factor in declining stock prices, stating that stock values ideally should be determined by "the quality of the company itself," "supply and demand" of the company's shares, and the company's ability to generate positive income. The SEC's short selling FAQ criticizes what it claims are common misconceptions about the practice. For example, the SEC website denies that naked shorting causes "phantom" shares to enter the market: Naked short selling, the SEC said, would not increase a company's shares outstanding shares nor result in "counterfeit shares."[1]

Statistics on failures to deliver securities are sometimes used as evidence of naked short selling in specific stocks. However, the U.S. Securities and Exchange Commission stated in January 2008 that "fails-to-deliver can occur for a number of reasons on both long and short sales. Therefore, fails-to-deliver are not necessarily the result of short selling, and are not evidence of abusive short selling or 'naked' short selling."
[40]

At a North American Securities Administrators Association (NASAA) conference on naked short selling in November 2005, an official of the New York Stock Exchange stated that NYSE had found no evidence of widespread naked short selling, and alleged "fear mongering that there's this rampant naked shorting that's gone unregulated." At that conference, Cameron Funkhouser, NASD senior vice president of market regulations, noted that although companies have alleged stock manipulation through the Berlin stock exchange, the NASD has seen "not one instance of naked short selling [on the Berlin stock exchange]". An official of the SEC said that "While there may be instances of abusive short slling, 99% of all trades in dollar value settle on time without incident."
[41]

Short seller David Rocker has contended that failure to deliver securities "can be done for manipulative purposes to create the impression that the stock is a tight borrow." In such a situation, the failure to deliver would be on the part of "longs," not "shorts."[42]

There is a debate regarding the extent to which DTCC is involved.
[43] DTCC says naked shorting is not widespread enough to be a major concern. "We're not saying there is no problem, but to suggest the sky is falling might be a bit overdone," DTCC's chief spokesman Stuart Goldstein said.[44][45] DTCC General Counsel Larry Thompson calls the claims "pure invention."[45]

A study of trading in initial public offerings by two SEC staff economists, published in April 2007, found that excessive numbers of fails to deliver in IPO's were not correlated with naked short selling. The authors of the study said that while the findings in the paper specifically concern IPO trading, "The results presented in this paper also inform a public debate surrounding the role of short selling and fails to deliver in price formation." [46]

Even though fails to deliver are viewed by some as a way of measuring the degree of naked short sales, the SEC economists said the delivery failures seen in the IPO market "cannot be explained by short selling in general or 'naked' short selling specifically."[47]

An April 2007 study conducted for Canadian market regulators by Market Regulation Services Inc. found that fails to deliver securities were not a significant problem on the Canadian market, that "less than 6% of fails resulting from the sale of a security involved short sales" and that "fails involving short sales are projected to account for only 0.07% of total short sales." [48][49]

Until at least 2007, most Wall Street financial journalists took the position that naked short selling is not harmful and its prevalence has been exaggerated by corporate officials seeking to blame external forces for their own shortcomings.

Wall Street Journal columnist Holman W. Jenkins, Jr., has derided naked shorting allegations, and claimed that "fails were more like an acceptable kludge, helping the market work better, than a cesspot of corruption liable to bring down the financial system." [50]

In the New York Times, several columnists have criticized the campaign against naked short selling. Chief financial correspondent Floyd Norris contended that investors of stocks that are being shorted "might do better to try to understand why some think the shares are overvalued, rather than simply rail about unfair short selling."[51].

New York Times financial columnist Joseph Nocera has criticized naked shorting allegations as diversionary complaints, and said that "most people who understand the issue or have looked into it think it's pretty bogus."[52]

Author, columnist and former Business Week investigative reporter Gary Weiss maintains that the SEC enacted Regulation SHO in part due to pressure from a handful of small and microcap companies.[53] He also cites economic justifications for naked short selling and downplays its significance as a problem for the market. [53][54]

Naked short selling critics

The SEC estimates about 1% of shares that change hands daily, or about $1 billion, are subject to delivery failures. The SEC views this $1 billion/day number as a serious enough matter to have made two separate efforts to restrict the practice.[55]

The SEC hired an economist, Leslie Boni, to investigate this issue. In 2006 she wrote a seminal paper, "Strategic Delivery Failures in US Equity Markets", showing that delivery failures were much more prevalent than had previously been thought, that the mechanisms that were supposed to stop them were triggered in .12% of the relevant cases, and that the distribution of delivery failures showed purpose and could not be explained as random human error. As her paper's summary put it: "Sellers of U.S. equities who have not provided shares by the third day after the transaction are said to have 'failed-to-deliver' shares. Using a unique data set of the entire cross-section of U.S. equities, we document the pervasiveness of delivery failures and evidence consistent with the hypothesis that market makers strategically fail to deliver shares when borrowing costs are high. We then show that many firms that allow others to fail to deliver to them are themselves responsible for fails-to-deliver in other stocks."

Robert J. Shapiro, former undersecretary of commerce for economic affairs, has claimed that naked short selling has cost investors $100 billion and driven 1,000 companies into the ground.[56]

The North American Securities Administrators Association, representing state stock regulators, filed a brief saying that if these claims were correct, its shareholders "have been the victims of fraud and manipulation at the hands of the very entities that should be serving their interest."[57][3][4]

Ralph Lambiase, head of the Connecticut Securities Agency and the NASAA, declared his disappointment at how the industry was handling the issue as a whole.[Citation Needed]

In early 2006, Bloomberg Magazine's Bob Drummond wrote "The Corporate Voting Charade", claiming that naked shorting was creating so much phantom stock it was ruining corporate democracy. As the article's subtitle put it: "One share does not always equal one vote in the crazy math of proxy contests. When short sellers borrow stock, investor democracy can be a sham."

In September, 2006, Bloomberg Magazine's Bob Drummond wrote "Games Short Sellers Play", alleging that "Traders who sell shares they don’t own—and haven’t even borrowed—are driving down prices. More than 425 companies a month may be the victims of these schemes."

In February, 2007 Forbes Magazine published two stories supporting the view that naked shorting is a serious problem in US capital markets. One article, "Naked and Confused", described the naked shorting attack on Sedona, a Pennsylvania software firm. Another article, "Sewer Pipes", explored the apparent involvement of the Russian Mafia in this issue: "Hedge funds are posting nice returns from deals that may involve ex-cons, stock scammers--even the Mob."

In March 2007, Bloomberg Television featured a special on naked short selling, "Phantom Shares" that presented a sharp criticism of naked short selling in the US capital markets. Phantom Shares' was nominated for an Emmmy for Long Form Investigative Journalism. [58][59]

In May 2007, Max Keiser reported on naked short selling as part of a report on Al Jazeera's People and Power show. [60]

In July 2007, United States Senator Bob Bennett suggested on the U.S. Senate floor that the allegations involving DTCC and naked short selling are "serious enough" that there should be a hearing on them with DTCC officials by the Senate Banking Committee. The committee's Chairman, Senator Christopher Dodd, indicated he was willing to hold such a hearing.[61]

Also in July, 2007, Forbes published another article, "Naked Shorting Case Gains Traction" concerning the failure of the prime brokerage industry to get a judge to dismiss litigation by Overstock.com against them.

According to The Guardian, Bear Stearns CEO Alan Schwartz has maintained naked short selling played a role in the March, 2008 collapse of Bear Stearns.

Lehman Brothers CEO Dick Fuld has gone on CNBC to make this claim as well: "Lehman Brothers CEO Richard Fuld has instructed his legal staff to tell regulators that he has information suggesting that short-selling hedge funds colluded to help cause the demise of Wall Street investment bank giant Bear Stearns, sources told CNBC."

On April 3, 2008, SEC Chairman Chris Cox, testified to the United States Senate that the SEC is investigating whether or not Bear Stearns was brought down by "illegal naked short selling".

In May, 2008, The US Chamber of commerce made public [a letter] in which they said, "We are pleased that the SEC... recognizes the serious problems with naked short selling and is taking additional steps to curb this abusive practice. We agree with Chairman Cox that naked short selling is a serious fraud that needs to be eliminated. However, we remain concerned that the current proposal does not address critical aspects of this disruptive practice."

On July 15, 2008, "The Securities and Exchange Commission today issued an emergency order to enhance investor protections against "naked" short selling in the securities of Fannie Mae, Freddie Mac, and primary dealers at commercial and investment banks," as their press release stated.

On July 21, 2008, Reuters ran the story a headline about former SEC Chairman Harvey Pitt, "Harvey Pitt to SEC: Expand ban on naked short-selling". It opened, "Emergency action by regulators to rein in abusive short-selling in some large financial firms should be expanded to include the stocks of all public companies, a former top markets watchdog said on Monday."

On July 22, Reuters reported that "Debate rages over naked short-selling as SEC mulls extending ban". The Reuters story described the situation succinctly: "The SEC’s emergency rule rattled the trading community, which scrambled to understand how the rule would be enforced. The unprecedented rule came after the SEC announced plans to crackdown on rumormongering and has started examining whether broker dealers and investment advisers have controls in place to prevent market manipulation."

On August 7, 2008, the American Bankers Association released a letter requesting that the SEC extend the protections afforded some in its July 15 Emergency Order be extended throughout the market. "At a time, when the economy is clearly under stress, the commission has a responsibility to assure that destructive practices such as abusive naked short selling are stopped," said the letter dated August 7. Here is a Reuters story on this.

[1] The SEC states that "Naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules," and clarifies that in some circumstances, it can contribute to market liquidity.[2]

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